September 30, 2014

Over the past 2+ years, increased risk levels have been a hallmark of the sustained upward movement in stock indices, as smaller, lower quality names have led the market (e.g., C & D rated stocks’ annualized 2-year return is 2x that of A+ rated stocks within the S&P 500 as of June 30, 2014, per BofA/ML US Performance Monitor).  Additionally, there is no doubt that the Federal Reserve’s (“Fed”) bond buying program (“Quantitative Easing” or “QE3”) has suppressed fixed income yields leaving investors with limited alternatives for real return outside of stocks.  This impact is demonstrated by the ~93% R-Squared of the Fed’s balance sheet and the price of the S&P 500 Index over the past five years.  To put this into perspective, the longer-term (from 2000 to 2014) R-Squared is 23%, which explains the ability of asset prices to continue their ascent in a more moderate growth environment as well as the very challenging half-cycle for those managers that focus on fundamentals.

With many of the major stock market indices continuing to move into uncharted territory (e.g., S&P 500, Russell 2000, Dow Jones Industrial Average, etc.) and the Fed planning to end QE3, now is not the time to embrace risk in our opinion.  As we move to a more normalized market environment, we feel that risk will ultimately be re-priced and fundamentals will take on a more important role.  In this environment, we expect higher quality companies with strong fundamentals to outperform their counterparts, especially if the U.S. economy fails to reach escape velocity or the sustained recovery that is being anticipated by many investors.

In our opinion, real Gross Domestic Product (“GDP”) growth for the U.S. economy will likely advance at a ~3% annualized rate in this year’s second half; but after negligible growth in real GDP in the first half, this pace would represent another year of less than expected growth in the range of 1.5 – 2.0% (similar to last year’s gain of 1.9%).  Since the beginning of the economic recovery five years ago, real GDP has advanced at about a 2% annual rate, nearly one percentage point less than in past multi-year periods of recovery and expansion.  Given the extreme levels of debt within the current economy, this is not surprising and is consistent with prior periods of growth during times of extreme leverage, as displayed in the “GDP Growth at Varying Debt Levels” chart below.

GDP to Growth June 2014

While the longer-term outlook for the stock market remains favorable, with recession risk low and corporate profits likely to hold up, the intermediate term outlook is more uncertain.  Valuation and sentiment data are stretched enough now to suggest that investors are taking too much short-term risk for too little reward.  We wanted to highlight another metric that, in our opinion, demonstrates the exuberance in the market.  The following chart presents the median market cap of the companies in the S&P 500 as a ratio of nominal Gross Domestic Product (“Nominal GDP”).

Mkt Cap to GDP June 2014

We used the median market cap to emphasize that speculation in the market has primarily come from the smaller companies within the Index.  We have been writing about this small cap speculation for some time, and the above ratio captures this effect well.  While other investors have claimed that the market is fairly priced, we would point out that those claims are based on a single year’s earnings and record levels of margins.  We don’t believe that approach to valuation is an appropriate proxy for discounting a company’s long-term profitability.  This is precisely why we have illustrated in past reviews that we believe the most appropriate way to discount a company’s future cash flows (using earnings as a proxy) is by using the company’s normalized earnings power.  Our calculation of market valuations on normalized earnings suggest that the S&P 500 is overpriced, trading in excess of 20 times earnings.  Looking at this chart, the speculative environments are clear – highlighting both the technology bubble in 1999 and the housing bubble in 2007.  As you can see, the current median market cap to Nominal GDP ratio has reached a new high, which we believe demonstrates the risk in the market, similar to the market peaks in 1999 and 2007.  As was the case then, which we believe to be true today, this is the wrong time to embrace risk.

The pockets of speculation in small cap stocks became more evident as volatility in these names increased during the most recent quarter.  While the market moved higher, there was turmoil below the surface.  The meaningful sell-off in price-momentum stocks that started in early March continued into the first few weeks of April, and seemed to presage a leadership change in the markets.  In fact, during April and May the Montag & Caldwell Institutional Equity (Large Cap Growth) Composite was up over 4% (over 1.0% ahead of the Russell 1000 Growth & S&P 500 Indices).  However, in early June, the European Central Bank announced additional liquidity measures.  This seemed to, at least temporarily, forestall the shift in leadership towards higher quality, secular growth companies as many of the speculative issues which led the market last year and early this year resumed leadership.

As we outlined last quarter, we think the volatility in both emerging markets and price-momentum issues may prove to be the canary in the coal mine of broader market volatility as the Federal Reserve ends QE3.  Although stock market volatility has been suppressed by Quantitative Easing, we still expect it to pick up as QE3 comes to an end and market forces, rather than Central Bank manipulation of capital markets, become a greater influence on asset prices.  While an increase in stock market volatility could be disruptive to investors over the intermediate term, an end to artificially high liquidity would be healthier over the long-term as free markets focused on fundamentals are far preferable to distorted markets and mispriced assets.  We feel that our clients’ holdings are well positioned for this transition to free markets and, given their strong fundamentals, should be appropriately rewarded as the market re-prices risk throughout the remainder of this market cycle.

Please click here to see the disclosures presentation for important information that is pertinent to this article.